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11/16/2008

Bail Out the Detroit Auto Manufacturers? Posner's Comment

Becker has laid out the case for refusing to bail out GM, Ford, and Chrysler. It is a powerful case, and if the drop in auto sales that is driving these companies toward insolvency had occurred two years ago, there would be in my view no case, other than a political one, for a bailout. But in the current financial crisis, I believe a bailout is warranted, provided that the shareholders and managers of the companies are not allowed to profit from it.
There are two types of corporate bankruptcy: liquidation and reorganization (Chapter 7 and Chapter 11 of the Bankruptcy Code, respectively). In a liquidation the bankrupt company closes down, lays off all its workers, and sells all its assets. That probably would not be the efficient solution to the problems of the Detroit automakers. They are still producing millions of motor vehicles per year, and if they suddenly ceased production entirely there would be a big shortage even though demand is way down. To put this another way, although at present the companies are probably losing money on virtually every vehicle they sell, at a lower level of production the price at which they sold their vehicles would exceed marginal cost.
The alternative to liquidation--reorganization--can work well in normal times, as in the United Air Lines bankruptcy that Becker mentions. The reorganized business is able to borrow money because its post-bankruptcy borrowings ("debtor in possession" loans, as they are called) are given priority over its pre-bankruptcy debts, which are usually written down in bankruptcy, reducing the reorganized firm's debt costs and thereby enabling it to recover solvency. The debts that get written down can include health and pension benefits, which in the case of the auto companies continue to be a big drag on profitability.
The major problems with allowing the automakers to be forced into bankruptcy within the next few months are three, all arising from the depression that the nation appears to be rapidly sinking into. The first problem is that the companies might have to liquidate, because they might be unable to attract the substantial post-bankruptcy loans that they would need to enable them to remain in business. The credit crunch--less politely the near insolvency of much of the banking industry--has made that industry unable or unwilling to make risky loans, and loans to the auto companies after they declared bankruptcy would be risky.
Second, not only the size of the automakers, but peculiarities of the industry, would cause bankruptcy to greatly exacerbate the nation's already dire economic condition. In the very short term, the automakers would probably stop paying their suppliers, which would precipitate a number of the latter--already in perilous straits because of the plunge in the number of motor vehicles being produced--into bankruptcy. Many of the suppliers would probably liquidate, generating many layoffs. At the other end of the supply-distribution chain, consumers would be reluctant to buy cars or other motor vehicles manufactured by a bankrupt company because they would worry that the manufacturer's warranties would be unenforceable. So more dealerships would close, producing more bankruptcies, liquidations, and layoffs. With the demand for the vehicles made by the Detroit automakers further depressed and the supply-distribution chain in disarray, the liquidation of those companies would begin to loom as a real and imminent possibility. Liquidation of the automakers would produce an enormous number of layoffs up and down the chain of supply and distribution. Such prospects reinforce the unlikelihood that a reorganized industry could survive on debtor in possession loans.
The likely psychological impact of a bankruptcy of the U.S.-owned auto industry should not be underestimated. Already consumers, rendered fearful by repeated misinformation from government officials concerning the gravity of the economic situation (including their reluctance to acknowledge that the nation was even in a ‚Äúrecession,‚Äù long after it was obvious to the man in the street that we were in something worse), are reducing their buying, precipitating big layoffs in the retail industry, which in turn reduce buying power, which in turn spurs more layoffs. This vicious cycle would be accelerated by the laying off of hundreds of thousands of workers in the automobile industry, including employees of suppliers and dealers as well as of the manufacturers.
The U.S.-owned auto industry may be doomed; it may simply be unable to compete with foreign manufacturers (including foreign manufacturers that have factories in the U.S.); or a reorganization in bankruptcy may be the industry's eventual salvation. But the automakers should be kept out of the bankruptcy court until the depression bottoms out and the economy begins to grow again. (Recall that the government bailed out the airlines after 9/11, allowing United Air Lines to have an orderly bankruptcy reorganization beginning the following year and ending in 2006.) Any bailout, however, should come with strict conditions, to minimize the inevitable moral hazard effects of government bailouts of sick companies. The government should insist on being compensated by receipt of preferred stock in the companies, on the companies' ceasing to pay dividends, and on caps on executive compensation, including severance pay.
A possible alternative would be for the government to refuse to bail out the industry but agree to provide the necessary debtor in possession loans to keep the auto companies from liquidating after they declare bankruptcy. But this would be a kind of bailout, and probably would not be sufficient to avert the shock effects that I have described.

'But the automakers should be kept out of the bankruptcy court until the depression bottoms out and the economy begins to grow again... The government should insist on being compensated by receipt of preferred stock in the companies...'

In the case of an eventual bankruptcy filing, i suppose the preferred stock will get a lower priority even compared to pre-bankruptcy debts. How then is the bail-out investment guaranteed/protected?

Hello Professor, first of all I want to apologize for my low level english and to manifest my most sincere admiration for your work, which I follow since many years ago. I know this question might be vague or maybe too ingenuous, but it is something that worries me and I could bet it worries many normal workers and entrepreneurs around the globe. I would like to know which are your perspectives for the duration of this crisis, at least in the impact form, how much time could it take until the new situation gets settled and we can see some stability? I know this question involves maybe some "future teller" conditions, but all I would like to know is a rational estimation. Thank you very much Professor Becker, it is always a pleasure to rea your blog, here from Latvia.

I believe that the labor unions have a strangle hold on our automakers, and it is largely their fault that the big 3 are in the mess they are in. Because of the unions, autoworkers' benefits are too fat to be competitive, and the cars they make are not tuned to the market. Now the unions want us - the very people who quit buying their crappy cars - to bail them out to the tune of $Billions. Labor unions have lost their relevance in the 21st century and until we break that cycle of free market abuse, I cannot support a bailout. The consessions they have made so far are only a drop in the bucket to what they need to do. I say close the unions down, take all the assets of the unions and give them to the automakers, and then let the free market take its course.

Posner is wrong on the alleged risk to DIP lenders re GM, unless I am wrong in assuming that the value of GM's assets (if liquidated) far exceeds the amount of necessary DIP financing. DIP lenders can acquire a superpriority lien on GM's assets and thus be covered even if the automaker were liquidated. Hence, I believe private lenders would step forward and, failing that, government DIP financing would not saddle taxpayers with further losses.

A prepack could work, if the financing is available and the unions amenable, for the latter's failure to budge would forestall such a plan. Private or gvmt-sponsored DIP financing would allow GM as DIP to reject contracts with franchisers, reject/renegotiate CBAs with unions (as in the United case), sell brands, and sell certain operations to more efficient capitalists -- leaving a company which can compete with foreign car companies with manufacturing in the US (and employ some large number though less than before). The Chinese and Indian markets will be available in due course to healthy automakers, but not to inefficient state-owned enterprises.

Suppliers would have claims for losses against GM as DIP, and would experience diminished business, but those which survive can invest in manufacturing future supplies for a no-longer-moribund GM, or for its now more powerful surviving rivals. Employment losses would be far from total among automakers and their suppliers.

Any healthy bank that wanted to participate in Ch 11 DIP financing would be free, I suppose, to do so. But the last thing we want to see happen is for sick Wall St (or Main St) banks that are already sucking down bailout cash to volunteer DIP credit for the Detroit 3 just so they'll have an excuse to ask U.S. taxpayers for a bigger bank bailout.

Did anyone else catch the Senate committee's hearing today? My take: votes aren't there to do an additional $25 Bil loan (bailout) outside bankruptcy but they can be put together to do DIP financing for any or all of the 3. A lot of the questions from Senators (largely drafted by staffers) were the same kinds you hear from a seasoned bankruptcy judge when a Ch 11 debtor and its lenders go in to seek approval of DIP financing terms. Globally, how do you intend to use the $$$ and how will you control your costs any better than in what got you here? I can't see any realistic prepack for GM or, probably, Chrysler. There's too much to unwind at GMAC, which Chrysler owns 51%, GM 49%. Ford maybe, except Ron Gettelfinger gave no indication that the UAW will voluntarily make any more economic concessions.

My wife has the finance degrees and the luxury of never having had to use them in the real world. So I asked her, "If we've got these 3 behemoth auto manufacturers with all these many years of experience right here in Detroit, U.S.A., how come NOT A ONE of them is healthy?" I mean, you'd expect at least one to be in a position to survive some rainy days. Her answer: current economic conditions in the U.S. constitute a state of affairs nobody's assumptions about business cycles ever contemplated. In the Great Depression days, in much of the country at least, people could fall back on agriculture and feed themselves. If cash was short, labor and barter weren't dirty words. But nowadays everything's credit and "monetization." Few Americans recognize a cotton seed from a soybean seed, much less have the knowledge or the tools to turn one into fabric, the other into food or feed. We've enslaved ourselves to monetized city life.

Nostalgia aside, the Detroit 3 as we've known them have finally hit the wall. But there's a decent prospect one, maybe two, could be rehabbed & successfully reorganized via Ch 11 without wrecking what's left of the rest of the economy.

Virtually all major manufacturing except automobiles has exited the U.S. Is it not inevitable that automobile manufacturing will eventually move offshore if not susidized? Is there something special about automobile manufacturing that makes it critical to keep it alive here in the U.S.? And, why are automobiles more important than steel, televisions and consumer electronics, microwave ovens, washing machines, memory chips (DRAM), computer boards, tools, etc.? Shouldn't we have subsidized these industries? I have trouble believing that restructuring the automobile companies will allow them to survive in the long term.

I think this will be the first test of whether Obama caves to lobbyists and special interests. The UAW and its members gave considerable amounts to his campaign and they expect to be repaid. Even if GM could considerably improve its margins and sales, it would not be able to meet its pension, wage and dealer obligations. The only long term solution is restructuring. The UAW would like the bailout because it is in effect a bailout of the unsustainable pension and wage obligations.

I really think that handing the failing auto companies to the UAW solves the problems in the funniest way possible. Clear the debts, and let the auto workers build competitive companies if they can, let them decide what they want to do.

NO WAY TO BAIL OUTS TO US AUTO COMPANIES!!! They need to file Chapter 11 and Reorganize! We can't reward poor management. And the gall for all three Auto Companies Executives to fly in on private jets to ask for a bail out. They don't just get it . . . they don't care for anything but the millions they make in paychecks, retirements and packages.

NO WAY TO BAIL OUTS TO US AUTO COMPANIES!!! They need to file Chapter 11 and Reorganize! We can't reward poor management. And the gall for all three Auto Companies Executives to fly in on private jets to ask for a bail out. They don't just get it . . . they don't care for anything but the millions they make in paychecks, retirements and packages.

NO WAY TO BAIL OUTS TO US AUTO COMPANIES!!! They need to file Chapter 11 and Reorganize! We can't reward poor management. And the gall for all three Auto Companies Executives to fly in on private jets to ask for a bail out. They don't just get it . . . they don't care for anything but the millions they make in paychecks, retirements and packages.

NO WAY TO BAIL OUTS TO US AUTO COMPANIES!!! They need to file Chapter 11 and Reorganize! We can't reward poor management. And the gall for all three Auto Companies Executives to fly in on private jets to ask for a bail out. They don't just get it . . . they don't care for anything but the millions they make in paychecks, retirements and packages.

I am trying to grasp the logic of putting 700 Billion Dollars out for the mortgage and insurance industries to survive but not provide a dime for the Auto Industry ??? Everything that I've read indicates the negative impact will be far worse if we don't help !! How many jobs have to be lost ? How many additional mortgage defaults ? How many health care premiums won't get paid !! How many groceries stay on the shelf ? How many other goods and services will fall by the wayside ?? Most of the money comes from the hard working people of America and we are about to stick it to us one more time !! The very rich will just be not as rich , the rest of us will take the bigger hit !! The "let the chips fall where they may" mentality is hardly doing the average american any favors. If that's is the way our leaders want to take it than let's take the 750 billion dollars of "bail out" money off the table too !! Let's see just how many jobs and people we can wreck at once !! Next election we'll see how many of our elected leaders get their positions renewed !!

As far as who's flying around in what, why don't we poll all our elected officials and add up how much of our tax dollars go to "comfort" travel !!I've flown coach all my life !! Can they say the same ?? Squandering money isn't exclusive to corporate america !! Some of the most ridiculous waste to date is in our own government !!.. At every level !! Let's keep our eye on the bigger picture , the thought of bread line and living on the street isn't a thought i care to dwell on and, as dramatic as that statement is , it can happen to a lot more people than we think !!

Kay, No harmonization of interests; Industrial, Agricultural, Commercial, Governmental? Ready for the unemployment rate to jump to 9-10 percent? That's what is going to happen if Chapter 11 becomes the only viable solution. I hear Dell is on the ropes as well and thinking of shuttering it's Austin operations and the UT is thinking of cutting 30% of it's staff. What about Motorola down there? I hear they're cratering as well and contemplating shutdowns and massive layoffs.

Know any good ranches in the area that need Hands? Oh! that's right, the ranches aren't needed any longer. Argentinian Beef is the wave of the future.

On DIP: GE Cap exited this line last month, because it was no longer able to syndicate DIP loans. Even if large amounts of capital were still available for DIP, an automaker would be high risk, because the assets are primarily plant and equipment that would be difficult for lenders to sell if the reorganization failed. So the government would be the only source for DIP, but the politicians would benefit more from using equivalent funds for a bailout. Perhaps, as Prof Posner suggests, the economy would benefit more in its current perilous state from a bailout than from a Ch 11, but it will be a political rather than an economic calculation determining the form of government aid.

To the overely intelligent- maybe you should do a little research on the reliability of domestic automobiles. The chances of a Chevrolet Impala break down is one hundreth of one percent more likely than a Toyota Camry at a sticker price of almost $10,000 less.
I can appreciate everyone being upset at the way the big 3 have mis-managed funds. For over a century the domestic auto manufacturers have been the back bone of the U.S. economy.Paying trillions of dollars in taxes and are responsible for millions of jobs. The government of the great country of the United States has allowed Japan to move in and take over the largest industry we have and accept no blame. What do they do instead? They belittle the CEO's as if they were children because they flew into Washington in their personal jets. TRILLIONS OF DOLLARS in tax payer money!!!!! They are the only reason WE CAN AFFORD TO HAVE those over privledged politicians sitting there to judge them.
I love BIG GOVERNMENT support!